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Finance

Terms in this set (108)

Promoting social values
is a goal that may influence a for-profit business
Something that adds value should either
increase the expected level of cash flows or decrease the riskiness of cash flows
Cash flow is a more reliable indicator than net income
of a firm's ability to pay it's bills, make its interest payments, and pay dividends to stockholders
Lower variability of cash flow is an indication of lower risk
which would increase the value of an asset
Liquidity
adds value to the markets and creates efficiency because it makes the facilitation of transactions more readily available
Implicit in the determination of economic value as it is practiced in finance
is the ability to express an asset's value in terms of cash.
4 factors that influence valuation
Cash flows
Time
Risk
Opportunity Costs
Market efficiency
refers to the ability of a market to adjust to relevant information.
Markets are said to be efficient
if they quickly and accurately assess relevant information and translate that information into prices.
The goal of finance is to
maximize shareholder's wealth
Valuation
the ability to accurately estimate what an asset is worth in economic terms
Accruals represent expenses that are
recognized in the company's income statement, but have not yet been paid for in cash
Primary characteristic of efficient markets
Competition
Originally developed by Professor Eugene Fama of the University of Chicago,
the Efficient-Market Hypothesis (EMH) asserts that financial markets are "informationally efficient."
Weak Form EMH
long-term returns in excess of the market are possible by conducting superior fundamental research and analysis of stocks, bonds, and markets.
Semi-Strong form of EMH
it is believed that asset prices reflect all publicly available information, and that prices instantly change to reflect new public information.
Strong form EMH
it is believed that asset prices reflect all publicly available and non-public "insider" information, and that prices instantly change to reflect both types of information.
The Securities and Exchange Commission, or SEC
is an agency of the United States federal government, and has the primary responsibility of enforcing US securities laws, proposing new rules, and regulating the participants of financial markets. Its mission is to protect investors.
The mission of The Federal Reserve Board, or FRB, is to
protect consumers and govern the banking institutions. It also controls the changes in money supply and interest rates, known as monetary policy, in order to keep the economy stable. When banks are in financial trouble, the FRB is their last resort lending source to stay liquid.
Financial Industry Regulatory Authority, or FINRA, is a
not-for-profit entity that regulates securities firms for the purpose of protecting investors. Licensed individuals and firms, such as brokerage houses, must adhere to FINRA guidelines. The ethical standards upheld by FINRA are extensive, and education for investors is provided through the organization.
The Public Company Accounting Oversight Board, or PCAOB,
is the regulating body that keeps an eye on accounting practices, including auditors and audit reports. The PCAOB is governed under the SEC and was the result of the 2002 Sarbanes Oxley Act (SOX): a regulation put into place after fraudulent activity in a company called Enron was not reported by its auditors, Arthur Andersen. Arthur Andersen had a high degree of accounting activities with Enron, and the majority of its revenues came from that while a fraction of revenues came from auditing services. This conflict of interest was no longer allowed after SOX.
The three primary financial accounting statements`
--the income statement, the balance sheet, and the statement of cash flows
Financial statements are important
because they are the primary tools used by the firm to communicate with its varied stakeholders.
The income statement
shows a company's revenues and profits over some time period, usually a year or a quarter.
It always begins with the revenues or sales to customers for the period. It then shows the costs of products or services incurred to make these sales.
The costs listed first on the Income Statement are the direct costs associated with the sales, such as materials and manufacturing labor. These items are often combined into a single cost of goods sold (COGS) or cost of products sold line. Subtracting these direct expenses from revenues gives us the company's gross margin or gross profit.
Next come indirect costs, which include sales, general and administrative (SG&A) expense, depreciation and amortization expenses, and research and development expenses (R&D). All of these expenses are considered operating expenses. Subtracting these expenses produces the operating margin or earnings before interest and taxes (EBIT).
The most common non-operating expenses are interest expense and taxes.
Subtracting these items from the operating margin gives us the company's net income, or net profit.
The balance sheet (also called the statement of financial position)
shows a company's financial position at a point in time
Financial position
what the company owns and owes; that is, the assets the company owns and the various sources of financing it has used to acquire those assets, such as loans from banks and the investment of shareholders.
The income statement and balance sheet are tied together by several accounts.
Depreciation expense from the income statement accumulates in the accumulated depreciation account on the balance sheet. Net income, less dividends, accumulates in the retained earnings account on the balance sheet.
Net worth or book value
All the assets of the firm minus the liabilities and preferred stock
Earnings per share
The income available to common stockholders divided by the number of common shares outstanding
Cash flows from investing
The net cash flow that results from changes in the amount of a firm's long-term assets
Stockholder's equity
The total ownership position of preferred and common stockholders
Cash flows from operations
The net cash flow that results from a firm's production and sales activities
Capital budgeting analysis
The process of deciding what assets to buy
Roth IRA
A tax-sheltered retirement plan individuals can use to avoid taxes on portfolio returns
RMI stands for
Risk Management and Insurance
Investment bankers have 6 primary roles
Company/Industry analysis
mergers and acquisitions
raising capital via corporate offerings
sales and trading
private client services
back office support
The balance sheet is a snapshot of the firm's assets and the financing of those assets at a given point in time (that's why it's dated "as of" a particular date).
It is a listing of all the assets, liabilities, and equity of the firm and is based balance sheet equation:
Assets = Liabilities + Owners' Equity
Current assets
are either cash or assets that will be converted into cash within the next year.
Retained Earnings is accumulated over time, increasing or decreasing each year, according to
Change in RE = Net Income - Dividends
Net Income =
Dividends + Change in Retained Earnings
this year's retained earnings equal the sum of last year's retained earnings balance plus the change in retained earnings from the current year, or
New RE = Old RE + Change in RE
New RE =
Old RE + Net Income − Dividends
Ratios are useful in analyzing and comparing company performance
they standardize financial data
flexibility
leads us to look in the right places so we can correctly understand the current performance and position of the company.
evaluating whether the firm is achieving its stated goal to maximize shareholder wealth.
Current Ratio
current assets / current liabilities
Quick Ratio
(Current assets - Inventory) / current liabilities
Average collection period
AR / Daily credit sales
AR Turnover
Credit Sales / AR
Inventory Turnover
COGS / Inventory
Total Asset turnover
sales / total assets
Fixed Asset turnover
sales / fixed assets
OIROI
operating income (EBIT) / total assets
Optimal debt ratio
The amount of debt that minimizes the firm's cost of capital
Debt Ratio
Total Debt / Total Assets
Times Interest Earned
EBIT / Interest Expense
Return on Assets (ROA)
NI/Total Assets
Return on Equity (ROE)
NI/Equity
Gross Margin
Gross Profit/Sales
Operating Margin
EBIT/Sales
Net Profit Margin
NI/Sales
DuPont Equation
ROE = Net Profit Margin × Asset Turnover × Leverage Multiplier
Return on Invested Capital (ROIC)
Net Operating Profit After Tax / (Costly Capital)
After Tax Operating Profit
NOPAT = EBIT (1 − t)
FCFE
Net Income + Depreciation − CAPEX − Increase in NWC + Increase in Net Long-Term Debt
Economic Value Added
EVA = NOPAT − [WACC × (Costly Capital)]
RE Relationships to Know
Projected RE = Old RE + Change in RE
Projected RE = Old RE + NI − Dividends
Projected RE = Old RE + [(Projected Sales × net margin) × (1 − payout ratio)]
Discretionary Financing Needed
projected total assets
− projected total liabilities
− projected owners' equity
Sustainable Growth is a Function of:
Profitability (net margin)
Asset usage efficiency (asset turnover)
Leverage (assets/equity)
Plowback (dividend policy)
Dividends
(Old RE + Net Income) - New RE
CFO =
Net Income
+ Non-Cash Expenses
+ Decrease in Operating Asset Accounts
- Increase in Operating Asset Accounts
+ Decrease in Operating Liability Accounts
- Increase in Operating Liability Accounts
Gross Profit of Sales is
Sales minus cost of goods sold. From that result we subtract selling, general, and administrative expenses (which includes depreciation) to get down to operating profit or EBIT. Finally, we deduct taxes and interest and end with net income
Leverage Multiplier
Assets/Equity
Costly Capital equals
all interest bearing debt + total equity
FCFF (Free Cash Flow to the Firm)
EBIT - Cash Tax Payments + Depreciation - CAPEX - Increases in NWC (Net Working Capital)
CAPEX
Capital expenditure (gross property, plant, and equipment) changes from two balance sheets
NWC
Net working capital (current assets − current liabilities) changes from two balance sheets
Weighted Average Cost of Capital
a measure that includes the cost of debt and the cost of equity
Dividend Payout Ratio
Dividends divided by new income
Retention or Plowback Ratio
Portion of earnings the firm retains
Sustainable Growth Rate
is the only growth rate which allows the firm to maintain its present financial ratios and avoid the sale of new equity
Sustainable Growth Rate =
ROE (1 − b)

= NI/S × S/A × A/E × (1 − b)

where SGR is the sustainable rate and b is the dividend payout ratio (dividends / net income).
Compounding
Figuring out the future value of money you will invest
Discounting
Figuring out the present value of money you will receive in the future
Future Value =
present value X (1 + i) where i = discount rate
PV of Perpetuity
PMT / i
The value of any asset is equal to
the present value of the stream of expected cash flows discounted at an appropriate required rate of return
Risk
is defined as the possibility that the realized or actual return will differ from our expected return. More simply put, risk is the uncertainty in the distribution of possible outcomes
Two types of bond questions
Question 1: Given the discount rate, find the market price

Question 2: Given the market price, find the discount rate (aka "Yield to Maturity")
Yield To Maturity (YTM)
The average annual rate of return that investors require to receive on a bond if held to maturity.
Standard deviation
the measure of total risk
Duration
A measure of the interest rate sensitivity of a bond
Market Risk Factors
Unexpected changes in interest rates
Unexpected changes in cash flows due to tax changes
Business cycles changes
If coupon rate = discount rate,
the bond will sell for par value.
Lower correlation (closer to -1) =
Greater diversification (lower risk)
Required Rate of Return (also known as ROE) =
Risk Free Rate + Risk premium
Value of Preferred Stock
Vps=D/Kps
where Vps is the value or price of the stock, D is the annual fixed dividend and kps is the discount rate or required rate of return (not the dividend rate).
Value of Common Stock
Literally it says that if we want to know the value of a share of common stock today, we just have to estimate the future dividends forever, then discount them all back to the present.
SML
Security Market Line
Gordon Growth Model
Common stock dividends grow at a constant rate forever - A growing perpetuity
CFI - Cash Flow from Investments
CFI = Change in Gross Fixed Assets = (Change in Net Fixed Assets + Depr Exp)
Increasing accounts receivable may be a result of a decrease in the company's credit standards.
Lower credit standards may increase a company's sales and reported income
Dividend Growth Rate
the rate at which dividends are expected to grow each year for the rest of time - in general, should be close to the growth rate of the economy
Two-Stage Growth Model
Estimate cash flows for two different growth stages:
Stage 1: dividends grow at above-average rates
Dividends during this high growth period are forecasted to grow at 15%, making the dividend in one year (at time 1) $1 × 1.15 = $1.15. The year two dividend will be 15% higher than that of year one, or $1.15 × 1.15 = $1.32, and so on.
Stage 2: dividends grow at the industry average rate
In Stage 2, beginning in year 4, dividends are expected to grow at the industry average of 5%. Using this new rate we can calculate the year 4 dividend as $1.52 × 1.05 = $1.60. This dividend is the first in an infinite stream of future dividends in which each dividend is 5% larger than the one before.
Final Stock/Firm Value
PV(Stage 1) + PV(Stage 2)
to find the value of a share of stock today using the two-stage model we do the following:
Forecast the dividend cash flows for the super-normal period year by year.

Discount the super-normal dividends back to the present at the required rate of return.

Find the first normal growth dividend.

Use the Gordon Model to find the value of the cash flows from the end of the high-growth period through infinity.

Discount the Gordon Model result back to the present (remembering to place it in the appropriate time period).

Add the values from steps 2 and 5.
PE, or Price to Earnings, ratio is the dominant "Price-to-X" ratio.
When we set out to price or value a stock, we are really asking about the earning power of the stock or company. The PE ratio is directly related to this idea. It compares the stock price to company earnings, and is calculated as price/share divided by earnings/share.
Fisher Effect
R-nominal = R-real + inflation
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